Will Someone Please Tell Me What This Bitcoin/Blockchain Thing Is All About?

Everyone has heard of Bitcoin by now (by convention, it’s capitalized when used as a protocol and lower case when used as a unit of exchange, like a dollar), but very few understand the importance of the “blockchain” technology that underpins it. This article expresses no opinion one way or the other on bitcoin and other so-called “cryptocurrencies” as investments at current valuations. It is, rather, an introduction for the layman to the “foundational technology” (Harvard Business Review [HBR] Jan-Feb 2017 issue) of the blockchain that enables creation of cryptocurrencies such as bitcoin, ethereum, litecoin, ripple, etc. There are over 1,000, currently. Businesspersons, in particular, will ignore the blockchain at their peril.

First, a brief terminology primer. As the HBR article describes, what we call the Internet began in 1961 as a defense department project for communications among researchers at DARPA (Defense Advanced Research Projects Agency) and was christened the ARPANET. By 1989, it made its debut with the general public, but note this well—all the early names everyone thought would rule the world back then (Netscape, Alta Vista, Ask Jeeves, Prodigy, CompuServe, AOL, etc.) fell by the wayside. If you get the urge to invest in whatever you think the future is or will be with blockchain and Bitcoin, my advice is to take a cold shower, pour yourself your favorite libation and make no sudden movements until the urge to call your broker passes.

That said, here’s what Marc Andreessen, co-founder of the first browser, Netscape, and top venture capital investor (Andreessen Horowitz) has to say about Bitcoin and blockchain: “Bitcoin gives us, for the first time, a way for one Internet user to transfer a unique piece of digital property to another Internet user, such that the transfer is guaranteed to be safe and secure, everyone knows that the transfer has taken place, and nobody can challenge the legitimacy of the transfer. The consequences of this breakthrough are hard to overstate.”

Bitcoin gives us, for the first time, a way for one Internet user to transfer a unique piece of digital property to another Internet user, such that the transfer is guaranteed to be safe and secure, everyone knows that the transfer has taken place, and nobody can challenge the legitimacy of the transfer. The consequences of this breakthrough are hard to overstate.”—Marc Andreessen, co-founder of Netscape

We need to have some perspective on what the Internet is and how it ultimately spawned “peer-to-peer” (P2P) communication, which enables Bitcoin and blockchain. The Internet is possible because of something called TCP/IP (transmission control protocol/internet protocol). I am quoting here liberally from the HBR article cited above to explain this world-shaking technology that we all now take for granted. Before the Internet, when you made a phone call or sent a fax via analogue signals, you did so in a “circuit switching” environment. This means that a line had to be provisioned for you by Ma Bell for as long as you were talking. When finished, your “pipe” was available for someone else.

The Internet (digital) uses “packet switching,” which allows your voice or data to be chopped up into “byte” sized packets of 0s and 1s, with a header containing the address of the recipient and a timestamp. The whole enchilada is then flung out into cyberspace to bounce around as each packet finds the most efficient route to its destination, like water trickling down your windshield in a light rain. The packets are reassembled at the other end in order from the timestamps, and shazam: you’ve got mail, or a phone call. It’s hard for me to imagine the ginormous brains that are able to conceive of such things, but let’s just be glad they do and move on.

That is a “foundational” technology, which took 20 or 30 years to play out and become the infrastructure that makes our world possible today. Foundational technologies enable “disruptive” business models (HBR) which allowed Amazon to plant the equivalent of dynamite on “bricks and mortar” stores. Kaboom!

When you think of the Internet, you probably think of your favorite websites and your ability to send and receive emails. That dimension of the Internet is essentially a world in which traffic visits specific “sites,” that are protected by various layers of firewalls and other defenses. Starting around 1999, the public (or more accurately, your kids) became aware of a different dimension called peer-to-peer technology initially via Napster, which allowed users to swap music among themselves directly (no website) without paying the artists. P2P technology enables direct communication between users’ computers without going through a central server like the Google email server or iTunes music server. This is the start of the solution of being able to transfer value between computers without Financial Intermediaries, such as banks, clearing houses, etc. Napster was shut down in 2001, but P2P communication is alive and well, enabling things like blockchain, Dropbox and Google Drive.

Now let’s pause briefly and think about the concept of money. 8,000 years ago some Mesopotamian tribes began bartering with Phoenicians for goods and services. Sometime between 1,000 BC and 500 BC, various metals began to be standardized as a medium of exchange, which led ultimately to gold and silver becoming more universally accepted. Fast forward to the Bretton Woods conference in June of 1944, at which the soon-to-be-victorious Allies in the Second World War engineered a monetary regime they thought would be more conducive to international trade, by fixing currency exchange rates between countries and tying them to the U.S. dollar as the reserve currency, which at the time was backed by gold. By 1971, oil shocks, balance of payments deficits and inflation exposed cracks in the foundation, so Richard Nixon unilaterally took the U.S. off the gold standard, making the U.S. dollar, and thereby all other currencies tied to it, a pure fiat currency, backed by nothing more than public confidence in a Central Bank.

Then came the Great Recession of 2008, and out of the ashes of lost confidence arose, like a phoenix from the flames, Satoshi Nakamoto (no one knows to this day who he, she, they are), and “his” paper describing a new P2P electronic cash system he called Bitcoin, which was made possible by something we now call a blockchain (Satoshi referred to it as a proof-of-work chain). Louder Kaboom!

We use banks because we trust them to safe keep our money better than we can do it ourselves. We rely on the bank to know our account balance (its proprietary ledger), so that when we write someone a check, an enormously complex system enables the bank to debit our account and credit the recipient’s account at whatever bank within the system he/she/it uses. It works—mostly—until it doesn’t. On September 15, 2008, Lehman Brothers filed for Chapter 11 bankruptcy protection (the largest in U.S. history), prompting a flight of clients out of the bank, in no small measure precipitating the global financial crisis. It took years for the cascade of lawsuits to ultimately determine who was owed what, primarily because no one could figure out, among the rubble, who owned what. Lehman’s ledger was out of balance and had effectively turned to mud, which then metastasized to counter party ledgers at other institutions. You get the picture.

What if, in the utopian world Satoshi proposed, all ledgers were maintained on every computer in the system and were all continuously synchronized in real time, irrefutably and unimpeachably, so that every computer reflected the exact same balance for everyone, BUT no one knew the names attached to those balances—just that they were always in balance. This is the “blockchain,” and there are no names involved. For instance, if you were to drop a nuclear bomb on 99.999 percent of all the computers in the world, and if at least one remained, the “blockchain” would still exist, in balance, and correct. The blockchain would be a continuous record from the inception of whatever is being tracked to the present, which would be reflected on every computer in the system because of file sharing technology.

If you were to drop a nuclear bomb on 99.999 percent of all the computers in the world, and if at least one remained, the “blockchain” would still exist, in balance, and correct.

Did I mention a ginormous brain? Satoshi’s got one of those. You could say Bitcoin was conceived of by a long-dead Scottish economist, Adam Smith (1723-1790), who wrote the first modern work of economics, “The Wealth of Nations,” in which he proposed that the most common good is achieved by individuals pursuing their own self-interest. His theory is beyond the scope of this discussion, but it was not beyond Satoshi. What if one could devise, he reasoned, an endless series of extremely complex mathematical problems, based on number theory and computer science, such that the first person to solve a given problem would be rewarded with a new kind of currency that, by its design, is scarce and therefore will gain in value?

These problem solvers are called “miners,” as they are, in effect, mining for bitcoin by solving mathematical puzzles. This concept is based on game theory, which incentivizes miners to always work on the longest blockchain, which is the most complete history of transactions. The winner gets to enter a new block of pending transactions into the sequential blockchain record, which is immediately updated on all ledgers, thereby preventing any possibility of a “double spend,” which is analogous to someone bouncing a check for insufficient funds. This becomes the new verified reality for everyone everywhere. I must here beg your forbearance. The theory and practice of how this process works is just plain too difficult for me to even begin to understand, much less explain. If you spend any time at all on message boards devoted to this science, you will quickly see that unless this is your field, and you are immersed in it, you simply will not be able to follow “nodes,” “nonces,” “hashes,” “blockchain forks,” “orphaned blocks,” and “proof of work,” all of which are the stock-in-trade of this bizarre new breed of cyber worker called miners. I ask that you not stop reading here, but rather do what I do in this gnarly briar patch. Accept that big brains get this stuff, make it work and move on. I can’t tell you why a 775,000 lb. Boeing 777 defies gravity, but I assume it won’t fall out of the sky, so I ride and move on.

Unlike a traditional bank balance of the amount in your account, the amount of bitcoin you possess in the blockchain is the cumulative transaction record of all your specific bitcoin from its mining, when it came into being, to its travels throughout the economy, as it is saved or spent over time. The blockchain actually follows each individual bitcoin—just like a physical dollar bill, versus credits and debits in the banking system—from owner to owner. The reason the blockchain knows you have a bitcoin to spend is that it knows every transaction that has ever occurred since that particular bitcoin was created by mining at inception. If you have it now, it is because you have not previously spent it, and the blockchain knows that. Any attempt to finagle with these balances would not be accepted, because every participating computer has a complete record of every transaction from the get-go. A miner up to no good would need to, in effect, change history, as he would have to alter the transaction record of all bitcoin ever created on more than 50% of all computers in the system, since acceptance of a block of pending transactions requires a “vote to accept” of a majority of all computers participating. One of the foundational assumptions of Satoshi and the system he conceived is that it incentivizes the majority of miners to be honest (game theory), as it is more profitable to be honest than to cheat in this system. The cost to nefarious miners to marshal more computing resources than the aggregate of all miners is prohibitive.

Mining is a rabbit hole you don’t want to venture into too deeply—leave it to the computer scientists. Briefly, massive consortiums of computer syndicates are located in cold places with cheap electricity supply (Iceland, Kazakhstan, Northern China) to cut down on the costs required to cool vast seas of server racks. These miners compete with each other to solve the mathematical puzzle first, thereby winning the right to enter the current block of pending transactions into the permanent record and hence earn bitcoin. This is such big business that a new kind of computer chip, Bitcoin ASIC, has been specifically optimized to solve the proof-of-work puzzle as fast as possible. A hoard of self-serving unbridled capitalists elbowing each other to win the race and stuff their pockets with bitcoin ensures the security and integrity of the system so we all benefit. Adam Smith was apparently whispering in Satoshi’s ear from the grave. I know this is difficult and frustrating to follow. Forget the jargon and gobbledygook and just know that the purpose of the exercise is to establish a winner who gets to be THE timestamp in the one true history of all bitcoin, so that everyone has THE most recent valid chain. That chain is the history of every single bitcoin everywhere. The prize is bitcoin. Pretty darned amazing, actually. We don’t have the slightest idea where the dollars in our pockets have been since they rolled off the mint, but we know the complete history of every bitcoin.

…the purpose of the exercise is to establish a winner who gets to be THE timestamp in the one true history of all bitcoin, so that everyone has THE most recent valid chain. That chain is the history of every single bitcoin everywhere. The prize is bitcoin.

This entire concept is so mind-boggling it would take massive research efforts at all the world’s top universities, think tanks, global and central banks to vet, challenge and stress test before any reasonable person would ever dream of using it. Well, it turns out they have and are actively participating as we speak: U.S. Federal Reserve, Foreign Central Banks, Harvard, MIT, Carnegie Mellon, UBS AG, J.P. Morgan, IBM to name just a few. Again, for our purposes, it’s best to just leave the mining briar patch and move on.

We are all painfully aware of hacking, so how can any of us ever come to trust a system in which all our balances are on the blockchain pseudonymously, for all to see? Are we really to believe no one could crack the code, see what we own and take it from us? It has to do with the science of asymmetric cryptography, which is fundamentally different from many standard firewall defenses that are so often breached. Cryptography is based on number theory and is far beyond the scope of this discussion. Suffice it to say that while nothing in life is absolute, cyber experts agree that the science of cryptography offers the most reliable form of cyber-protection the mind of man has yet devised. We have a private key to our “pseudonymous profile” and everyone else has a public key to see our (and all) transactions. As long as you do not lose your private key, or keep it somewhere where someone could get to it (on your computer, say), no one, including you if you lose it, can transact on your behalf. Everyone can see everything on the blockchain, but no one can see who owns it—it’s just numbers—but any monkey business is immediately apparent to everyone. The system will not accept a bogus transaction, as it would throw all the ledgers out of whack and be apparent to all. For a discussion on how your identity could conceivably be determined, click here.

The safekeeping of your private key is absolutely critical. If lost or stolen, you’re in a world of hurt. Many people use “hot” storage of a private key (protected on their computer which is connected to the internet) for a bitcoin account of day-to-day smaller balances, the loss of which would not be catastrophic, and “cold” storage for a separate account with more substantial sums. Cold storage means either a piece of paper containing your private key held in a safe deposit box or other offline unassailable fortress or on a computer that has NEVER been connected to the internet—not just currently. If the dog ate your cold storage homework paper with your key written on it, those bitcoin are lost forever. There is no such thing as a computer scientist being able to get into your blockchain transaction record and restore it to you without your private key. Those bitcoin, while still on the blockchain, are unspendable and therefore effectively cease to exist, which adds a deflationary component to cryptocurrency.

Why in the world should I trust Bitcoin? Well, why did the Phoenicians trust the wheat the Mesopotamians gave them in return for goats? Why do we think gold is valuable as a medium of exchange or that a piece of paper (a dollar bill, for instance) will settle a debt etc.? The answer is always and everywhere the first law of economics—abundance and scarcity.

Why in the world should I trust Bitcoin?…The answer is always and everywhere the first law of economics—abundance and scarcity.

Let the printing presses roll unconstrained, and you get wheelbarrows full of worthless German marks after World War I or a one trillion dollar Zimbabwe banknote (no lie). Only 21,000,000 bitcoin can ever be mined (created via solving mathematical puzzles and earned by the winner of that competition)—ever, and that will occur sometime in 2040. That finite limit is, again, a function of number theory, so we math-challenged mortals will just have to accept that as fact. To the extent that bitcoin and other cryptocurrencies gain a following as a medium of exchange, that scarcity can support its value. Today we’re in the Wild, Wild West of this 20- or 30-year foundational infrastructure being laid. Tomorrow’s winners are unknowable today, but, as Bill Gates said recently, “Bitcoin is exciting because it shows how cheap it can be. Bitcoin is better than currency in that you don’t have to be physically in the same place and, of course, for large transactions, currency can get pretty inconvenient.”

Metaphysical alert: Whereas a credit balance in your bank account started life as “money supply” from the Central Bank’s magic wand, and from there, diffused into the commercial banking system, cryptocurrency was “mined,” bringing it into being as a unique, identifiable entity which can be followed pseudonymously throughout the blockchain. It has a physical presence, in a non-physical way (No, Dr. Timothy Leary was not involved in this project).

A UBS Group Technology White Paper entitled “Building the Trust Engine” lays it out this way: Over the last two millennia, as societal and financial requirements have become ever more complex, humans have developed the need for “trusted third parties” to enable all manner of transactions to be carried out safely and easily. Blockchain removes the need for a trusted third party and replaces it with an immutable system of distributed ledgers that are always correct, in which there is no one to trust, because you have no idea who the counterparty is. Your trust is in the blockchain. This will not happen overnight. It will take respected third parties such as those mentioned above joining the system and using it for critical applications. The public will then begin to “trust the system,” and its use will proliferate.

What is important to know is that almost no business you can think of, beyond perhaps a haircut, will be unaffected. A number of global banks have been studying this technology, as it can pose an existential threat to many of a bank’s traditional businesses. But like every new technology, new opportunities are created for those in a position to capitalize on the opportunity. The gateway into the blockchain, for instance, will become extremely important. It seems to me, someone should have to certify you are who you say you are to allow you onto the blockchain, because once in, you are pseudonymous and your record of transactions, when accepted, becomes part of the permanent record. This pseudonymity feature is probably how you first heard of Bitcoin, to wit: drug dealers and other ne’er-do-wells transacting illicitly. Solving the gateway conundrum will entail years of societal debate on the important issues of privacy, government intrusion, regulatory need versus overreach, etc. The debate will rage on as blockchain and cryptocurrencies extend their reach into every aspect of our lives.

Applications will proliferate, limited only by your imagination. Works of art, once irrefutably certified by unimpeachable appraisers, will enter the blockchain, with their provenance, so that fraud and counterfeiting become impossible in future transactions from that point forward. Your house, medical records, voting records etc. will all become part of the blockchain, making identity theft virtually non-existent. A new breed of “smart contracts” will live on the blockchain, like stocks that pay their own dividends and do not require custody and transfer agents. Smart car lease contracts will shut off the engine if the lease payments are not made. Payment for everything occurs immediately, so the credit risk between transaction and settlement is eliminated, unless financing is agreed to and arranged. Estate planning provisions in trusts and wills will spring into action with the input of a date of death. When you buy an orange at Whole Foods with a stamp that says “organic,” do you REALLY know that it is? The blockchain will follow that orange from the fertilizer used in the field, the spraying done or not done, to the picking, to the truck, to the wholesaler, to the retailer. Manufacturing supply chains will be revolutionized with unimagined precision, and on and on.

So why in the world are these cryptocurrencies in the news so much and trading in such wild swings? I have no opinion as to the investment merits of any cryptocurrency. Period! I don’t own a single solitary farthing of any of them and likely won’t any time soon, other than possibly as a curiosity to understand how the “Bitcoin Wallet” (how Bitcoin is stored online) works mechanically. My interest is much more on the blockchain side of the ledger, but in saying that, I am not discounting what Bitcoin is and what purpose it serves. There is no blockchain without some kind of reward for time-stamping a pending block of transactions, and it so happens, at least so far, that mining for bitcoin is that reward.

The optimistic case is that in the world, depending on how you define money (M1 & M2 for these purposes), there is somewhere around $60 trillion dollars in equivalent total currency. If all fiat money were to be discredited AND only one cryptocurrency existed, AND it was the only medium of exchange, AND became universally adopted, each bitcoin could conceivably be worth $2,857,142 ($60 trillion/21 million). None—REPEAT—none of those phantasmagorical things are going to happen, but the Bitcoin Bulls make numerous assumptions, calculations, adjustments, wishful thinkings, and arrive at some discounted, Rube Goldberg, chitty, chitty, bang, bang present value approximation as to what might be possible.

The negative case is the whole concept blows up, and Bitcoin is worth 0. The truth lies somewhere in between. Aye matey, there’s the rub. Somewhere between 0 and infinity, for all practical purposes, is immune to any quantitative analysis. You pays your money; you takes your chances on the value of a cryptocurrency. In addition, what happens to the value of Bitcoin when interest rates rise and traditional cash earns a return? Adam Smith would say the market will figure that out, and I’m sure it will.

On the adoption of the foundational technology of the blockchain and how it will change everything over the next 30 years—you can take that to the bank. Spend your time and money thinking about how blockchain will impact your business and improve your life. That investment will pay big dividends. On the matter of speculating on cryptocurrencies and ICOs (initial coin offerings)—it’s simply above my paygrade. There will be winners and lots and lots and lots of losers. Remember these guys: Netscape, Alta Vista, Ask Jeeves, Prodigy, CompuServe, AOL?

Thomas L. Wentling Jr. is a Financial Advisor with UBS Financial Services Inc., a subsidiary of UBS AG, Member FINRA/​SIPC, 5600 Walnut St., Pittsburgh, PA 15232. The information contained in this article is not a solicitation to purchase or sell investments. Any information presented is general in nature and not intended to provide individually tailored investment advice. The strategies and/​or investments referenced may not be suitable for all investors as the appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Investing involves risks and there is always the potential of losing money when you invest. The views expressed herein are those of the author and may not necessarily reflect the view of UBS Financial Services Inc. Yield is the income return on an investment. This refers to the interest or dividends received from a security and are usually expressed annually as a percentage based on the investment’s cost, its current market value or its face value. Diversification does not guarantee a profit or protect against a loss in a declining financial market. As a firm providing wealth management services to clients, we offer both investment advisory and brokerage services. These services are separate and distinct, differ in material ways and are governed by different laws and separate contracts. For more information on the distinctions between our brokerage and investment advisory services, please speak with your Financial Advisor or visit our website at ubs​.com/​w​o​r​k​i​n​g​w​i​t​h​u​s.